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Friday, January 13, 2012

Bullard's "Death of a Theory" Paper

Jim Bullard has posted his "Death of a Theory" paper here. This is essentially a call for a return to pre-financial-crisis views of the relative efficacy of fiscal policy and monetary policy for stabilization. Before the financial crisis, even New Keynesians were primarily focused on monetary policy. Mike Woodford's "Interest and Prices," for example, is almost exclusively a handbook on monetary policy. The views of New Keynesians on fiscal policy seemed to have been more or less consistent with those of Milton Friedman. Fiscal policy matters, but fiscal policy is about the long run. The process of making fiscal policy decisions is awkward and time-consuming, and we know little enough about how the economy works that stabilization using fiscal policy is inappropriate.

Things have changed since the financial crisis, however. Governments have been putting fiscal policy to use for stabilization purposes, and New Keynesians have jumped on the bandwagon. Bullard's paper argues, in light of the evidence and the economics literature, that the pre-financial crisis view is entirely appropriate, i.e. fiscal policy should focus on the long run and leave the short run to the central bank. Bullard says:

In short, existing political processes are, generally speaking, far too cumbersome and contentious to enact effective and timely short-term actions in response to market events. They are ill-equipped to deliver the types of subtle tax and spending interventions that may actually be effective according to a careful reading of the available macroeconomic literature on the topic.

Here's part of what the content of the paper is about:

I will describe and comment on two strands of the macroeconomic literature in this area, one highly formalized and the other intuitive but rhetorically potent. The first is the heavily studied fi scal multiplier idea in the context of New Keynesian DSGE macroeconomics. The second is less studied and not formally articulated very often. It is that a substantial increase in de ficit-financed government purchases sends a signal to the private sector that a high growth regime is possible and likely going forward. This could influence private sector expectations and lead to a virtuous equilibrium in which actual output and employment are high. Rhetorically, this seems to be what many advocates have in mind, even if this is not what happens inside most of the macroeconomic models used to analyze this issue.

This is interesting, as it highlights an aspect of policy recommendations coming from hardcore Keynesians - Krugman for example - that do not make clear what the underlying source of inefficiency in the economy is. From a Keynesian point of view, the inefficiency could be sticky wages and prices, on the one hand, or a coordination failure, on the other. What the policy response should be depends on the inefficiency, though not every Keynesian understands this. As Bullard states, the type of coordination failure that some Keynesians appear to have in mind - self-fulfilling beliefs about the future driven by fiscal policy - has not really been formally studied.

22 comments:

Which begs the question: Does Bullard really think that the "unconventional" policies the Fed has been doing is "monetary" policy in the traditional sense? I mean 2 trillion dollar expansion of the balance sheet, part of which was direct purchases of various assets! Since when was this "monetary" policy? At least not according to Tom Sargent's textbook definition, in which fiscal policy is the determination of aggregate government liabilities (and spending), while monetary policy determines the split of those liabilities between base money and interest bearing riskfree government bonds (thus pinning down the short-term nominal interest rate).

I can't speak for him, but the paper certainly seems to indicate that he would consider everything the Fed has been doing as monetary policy. You could certainly argue that point. Suppose Fannie Mae and Freddie Mac buy mortages, package them as mortgage-backed securities (MBS), and then the Fed purchases them by issuing reserves. Suppose alternatively that the Treasury issues some T-bills and makes some mortgage loans. Is the former monetary policy and the latter a federal credit program? They both look the same to me. Maybe what you're getting at are the distributional implications. We don't want the Fed engaged in policies that have such obvious implications for who gets credit, who doesn't, and at what prices.

^ Just to follow up, the Fed thus has established the supremacy of "fiscal policy" at the expense of traditional monetary policy which of course goes completely against the point of what Bullard is saying.

"what the policy should be depends on the inefficiency"Isn't the major inefficiency today rent-seeking in the financial sector? This acts like a tax on the productive real economy, so we should eliminate this inefficiency.

There are some people that make a case for the this, for example Acemoglu. There is something to it I think. Again, the key work to do here amounts to determining what is productive financial activity and what is unproductive. You don't want to hit the financial sector with a blunt tool that destroys the wrong things.

Steve: Have you seen this paper?http://ideas.repec.org/p/nbr/nberwo/17063.html

Suppose govt. normally fails to provide an efficient level of government investment (partially nonrival capital like infrastructure, etc.). Suppose that crises provide a political impetus to partially correct this govt. failure. That would make stimulus quite effective, as long as it comes in the form of govt. spending on public capital goods (also recall Baxter & King 1993).

The multiple equilibria could be political-economic equilibria related to levels of public capital investment.

1. Yes, the "priming the pump" idea has been around for a long time. The people who wrote it into textbooks weren't thinking about multiple equilibria, but it's definitely a multiple equilibrium idea.

2. On the Bachman/Sims paper: When I see "structural" and "VAR" in the same sentence, my brain switches off.

3. On efficient government investment, etc.: That's a creative argument. However, you have to buy two ideas: (i) There's something preventing us from achieving efficient government investment in normal times. (ii) In crisis times that barrier goes away. The barrier you seem to have in mind is some kind of political economy/behavioral idea. The political process is screwed up in normal times, but in crisis times you can capitalize on the fact that the electorate has all been educated about the paradox of thrift, multipliers, etc. Then you can sneak the extra government investment past them.

3.(i) Well, as a conservative sort of guy, I'm sure you're amenable to the notion that government policy is almost always far from the efficient frontier. Theoretically, there is the Groves-Clarke result about nonrival goods that scale with population.

(ii) Actually I was being agnostic on the mechanism by which stimulus becomes more feasible during deep recessions. One idea is that people want more redistribution during recessions, and they see stimulus mostly as redistribution (as do many conservatives). Another possibility is that politicians feel the need to seem like they are doing *something* in response to the crisis. A third (and more optimistic) possibility is that politicians actually realize that they are not providing enough public investment, and that recessions are times at which efficiency concerns become so big that they trump distributional concerns.

But, to be honest, I think that it's more likely that the barrier simply *doesn't* go away in recessions. Stimulus in terms of public investment was very small, even in the current recession and in the Depression. Most "stimulus" was in the form of tax credits and state block grants that simply got saved. My pessimistic guess is that it takes war, or the threat of war, to raise public investment to anywhere near efficient levels (because in war, external threats outweigh domestic distributional concerns). Hence you had railroad construction in the Civil War, lots of R&D in WW2, and the interstate system during the Cold War. And really, wars are the most convincing piece of evidence that we have that stimulus actually works...Krugman et. al. say this quite often.

"Well, as a conservative sort of guy, I'm sure you're amenable to the notion that government policy is almost always far from the efficient frontier."

1. I actually think of myself as a liberal sort of guy who does economics.

2. You have to define efficiency. That can mean different things to different people.

"One idea is that people want more redistribution during recessions, and they see stimulus mostly as redistribution..."

If we want redistribution, the question then is how best to provide it. Maybe taxes and transfers are more efficient than expenditures on goods, services, and government capital. Maybe not.

"Another possibility is that politicians feel the need to seem like they are doing *something* in response to the crisis."

Yes, that's the Ben Bernanke effect.

"recessions are times at which efficiency concerns become so big that they trump distributional concerns."

Now you're arguing it's not distribution, it's efficiency that we should worry about. That's a standard Keynesian argument of course. There's a large output gap and we have to fix it.

"And really, wars are the most convincing piece of evidence that we have that stimulus actually works...Krugman et. al. say this quite often."

Yes they do. I think of World War II as a large sectoral reallocation. There's nothing Keynesian about it.

Like Bullard, I was quite surprised by the arguments for "stimulus" that were made when the financial crisis hit and the recession started. I thought Keynesian stabilization policy was dead, for reasons related to the Mankiw citation in Bullard's paper. I think one could make the case that the US government should be doing some things that it is currently not doing. But I think those are long-run issues.

1. I actually think of myself as a liberal sort of guy who does economics.

You know what I mean. ;-)

2. You have to define efficiency. That can mean different things to different people.

I meant Pareto.

If we want redistribution, the question then is how best to provide it. Maybe taxes and transfers are more efficient than expenditures on goods, services, and government capital. Maybe not.

No argument here. I was conjecturing on reasons why political support for stimulus might rise in recessions.

Now you're arguing it's not distribution, it's efficiency that we should worry about.

No, no! I'm just conjecturing a whole list of possible alternative reasons why political support for stimulus might rise in recessions. The reasons are not connected, nor do I endorse any of them.

But my more general point/conjecture is that maybe we live in an economy with multiple equilibria. Maybe some recessions knock us down to a bad equilibrium. And maybe the temporary elimination of political-economic constraints on optimal public investment can knock us back to a higher equilibrium. In that sort of world, fiscal policy has both long-run and short-run ("stimulus") effects.

This is a "pump-priming" argument for stimulus rather than the "hole-filling" arguments that everyone uses nowadays.

Efficiency: I have something else in mind. Once you enter into the political economy aspects of the problem, Pareto efficiency becomes more thorny. You have to worry about what problem the political process is solving, and how that relates to the problem of the fictitious social planner.

Multiple equilibrium: You may have something, but there could be a problem. It seems to me that the financial crisis and the recession have made the political process and the economic policy discussion more confused than ever. There are a lot of of militant angry people on the right and left, and not much consensus among the economists about what to do. It does not look like fertile ground for investment in public capital, any more than was the case pre-crisis.